How to Determine Optimal Capital Structure

Many people get confused about the optimal capital structure for a company because they observed that different company holding different capital structure. Capital can be formed by using only equity or combination of debt and equity, but cannot form only using debt capital. For a company debt and equity can be 50/50, for other company it can be 40/60, or 60/40, or 65/35 or any other proportion. Here question may arise that what proportion of debt and equity should use to form an optimal capital structure?

The optimal capital structure mainly depends on the two important things. These are:

• The financial risk of that company

Business risk arises when a company unable to generate a sufficient amount of cash flow to pay off its operating expenditures. Operating expenditure can be rent expense, salaries expense, wages, depreciation etc. The main thing is if the business unable to cover its business operation related expenditure then the company will exercise business risk. Lower the cash inflow, the higher the business risk and higher cash inflow from the operation will reduce the business risk.

So when forming an optimal capital structure it is required to keep in mind that the number of business risks which may arise. If there is a possibility of higher business risk then it will be a wise decision to use higher equity capital rather using debt capital. On the other hand, the company which generates a huge amount of cash flow from its business operation can use a larger amount of debt to maximize its return.

Business risk can be divided into two risk categories. One is systematic (non-diversifiable) and other is unsystematic (diversifiable) risk. As we cannot reduce the systematic we must diversify our investment so that we can reduce the risk of the company.

Financial Risk

Financial risk directly related to the interest amount payable to the debt provider. That is when a company is unable to generate sufficient cash flow to pay off the financial obligations properly then that company experience financial risk. A company with a sound financial position ensures less financial risk and the cost of debt financing is lower as the investment in this company is less risky.

Although business risk and financial risk are two broad things we have to keep in mind that some other factors like availability of equity capital, cost of equity, cost of debt, cash conversion cycle of the business, the profitability of the firm and corporate tax rate may involve with determining the optimal capital structure. Also, optimal capital structure (debt and equity ratio) depends on the type of business and economic condition of the company.

What are the Basic Types of Risk?

We know that future is uncertain, because of uncertainty; involvement of risk can be traced to our every part of life. When we talk about any investment we have to think about risk and return, higher the risk higher the rates of return and lower the risk lower the rates of return. Our life is directly related with economic activities where risk is the considerable element that cannot be overlooked.

To minimize the risk people go for savings and some people take the help of insurance companies/ agencies by paying insurance premium. Risk can be categories into different perspective but here we only discuss about the business risk.

Before discussing the types of risk, let’s have some idea of risk. Risk is the deviation between the actual outcome and expected outcome. Some risk can be minimized and some risk cannot be minimized. Some risk arisen from the micro economic factor and some from macro economic factors.

Basic types of risk that we may found are:

Basic Types of Risk

Unsystematic Risk

Unsystematic risk is that portion of risk which can be minimize through diversification of the investment by forming portfolio. If we form a portfolio using the negatively correlated investment securities then it would be possible to minimize the risk at lower level. This types of risk is known as diversiable risk Theoretically it is possible to eliminate the portion of unsystematic risk but in real sense it is not possible to eliminate the risk through diversification.

Systematic Risk

Systematic risk is that portion of risk which cannot minimize through diversification of the investments. Systematic risk is mainly arisen from the macro economic variables which are beyond our control. Beta is the measure of the systematic risk. Sometimes this risk is also known as systematic market risk. Sources of systematic risk are given below with short explanation.

Business risk is the risk which mainly arise when a firm or business organization unable to generate sufficient revenue to maintain its operating expenditure through providing service or selling products, that is risk is directly related with the operation of the firm.

Financial Risk

When a firm is unable to pay off its fixed financial obligation then this type of risk may arise. This type of risk is involved with the levered firm which uses debt capital for business. In some cases this risk can lead a lead a company to bankruptcy.

Liquidity Risk

This risk is involved with the marketability of a security or investment that is the capacity to generate asset into cash as much quicker as possible. If an investment is takes less time to convert into cash then it is liquid asset or investment.

Country Risk

Unstable political condition of a country is responsible for this type of risk. If this risk is more than an economy definitely fall, so does business. In our Bangladesh this type of risk is higher.

Exchange Rate Risk

Exchange of currency is required when a country is involved with import and export. For importing product or services foreign currency basically dollar is used. So if there is more fluctuation of the exchange rate frequently then a business may incur loss. This probable loss is the risk for the business.

Although every economic activity is involved with risk, we need to be more cautious to minimize the risk. If we can minimize the risk of doing business then it will be possible to generate profit for the company/ business organization.

Written by

Md. Nahian Mahmud Shaikat

Student of MBA

Jahangirnagar University

Email: [email protected]